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F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
New Absolute Return Strategies for WealthManagement
Francois-Serge Lhabitant Chief Investment Officer, Kedge Capital, Professor of Finance, H.E.C. Lausanne and EDHEC
f@lhabitant.net
2
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
References
– Chardon M., Lhabitant F.S., Mirlesse D. (2006), Absolute Returns in Wealth Management: Implementing Risk Controlled Strategies, The Journal of Financial Transformation, vol. 16, pp. 111-121.
– Lhabitant F.S., Mirlesse D. (2007), Global Asset Management, forthcoming at John Wiley and Sons, London, 288 pages.
3
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Question
How should we allocate to equities as an asset class?
4
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Long only managers
Long only managers are the traditional way of gaining exposure to equity markets.
Long only managersPortfolio with adjusted
market exposure
Equity Markets
5
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Little Evidence of Equity Alpha
Mutual fund managers under-perform equity indices on the long-run.
Indexing is more effective.
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
Larg
e C
ap C
ore
S&P
500
TR
Larg
e C
apG
row
th
S&P
Gro
wth
Mid
Cap
Cor
e
S&P
Mid
Cap
Mid
Cap
Gro
wth
S&P
Mid
Cap
Gro
wth
Smal
l Cap
Cor
e
S&P
Smal
l Cap
Smal
l Cap
Gro
wth
S&P
Smal
l Cap
Gro
wth
Lipper
LipperLipper
LipperLipper
Lipper
S&P S&P
S&P
S&P
S&PS&P
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
Larg
e C
ap C
ore
S&P
500
TR
Larg
e C
apG
row
th
S&P
Gro
wth
Mid
Cap
Cor
e
S&P
Mid
Cap
Mid
Cap
Gro
wth
S&P
Mid
Cap
Gro
wth
Smal
l Cap
Cor
e
S&P
Smal
l Cap
Smal
l Cap
Gro
wth
S&P
Smal
l Cap
Gro
wth
Lipper
LipperLipper
LipperLipper
Lipper
S&P S&P
S&P
S&P
S&PS&P
Return comparison of Lipper and S&P indices.
6
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Little Evidence of Equity Alpha
VALUE STOCKS
BLEND GROWTH STOCKS
Before tax
After tax
Before tax
After tax
Before tax
After tax
Large Cap 87% 97% 81% 94% 54% 80% Mid Cap 82% 91% 67% 84% 57% 78% Small Cap 43% 94% 17% 44% 16% 29% Source: Morningstar, BGI
Percentage of active managers under-performing their reference index (U.S. equity funds, from January 1995 to December 2004)
7
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Excessive fees
0%
5%
10%
15%
20%
25%
0.0 0.2 0.4 0.6 0.8 1.0
1% fee
1.5% fee
2% fee
Correlation with the market
Implied feesfor active management
8
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Long only managers
A long only strategy can be decomposed into an active and a passive component.
Passive strategyActive strategy
Indexing vehiclesLong/Short Managers
Long only managersPortfolio with adjusted
market exposure
Equity Markets
9
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Active Strategies:Long/Short Managers
– Active strategies– Aim at maximizing performance subject to constraints set by
investors.– Investing in skills.– Relative independence from the market cycles.– Possible underperformance during strong bull markets.– Importance of fee structure.
10
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Active Strategies:Long/Short Managers
Hedge fund indices tend to have significant beta exposure to equity markets. They have a long bias.
But it is still possible to find long/short equity managers that are relatively independent from market conditions.
R2
R2 heat map of an hedge fund index and several active managers regressed versus equity indices.
EDHEC L/S Mgr 1 Mgr 2 Mgr3 Mgr 4 Mgr 5. Mgr 6MSCI WORLD VALUE INDEX
MSCI Value North America USDMSCI EAFE VALUE INDEX
MSCI Value Europe USDMSCI WORLD GROWTH INDEX
MSCI Growth North America USDMSCI EAFE GROWTH INDEX
MSCI Growth Europe USDMSCI Emerging Markets
S&P BARRA VALUE INDEXS&P BARRA GROWTH INDEX
S&P 500 INDEXNASDAQ COMPOSITE INDEX
RUSSELL 2000 INDEXRUSSELL 3000 INDEX
RUSSELL 2000 VALUE IDXRUSSELL 2000 GROWTH IDX
RUSSELL 2000 TECHNOLOGYRUSSELL 2000 HEALTH CARE
RUSSELL 2000 CONSMR DSCRRUSSELL 2000 CONSMR STPL
RUSSELL 2000 INTGRTD OILRUSSELL 2000 OTHR ENERGYRUSSELL 2000 MTRL & PROC
RUSSELL 2000 PROD DURBLSRUSSELL 2000 AUTO & TRNS
RUSSELL 2000 FINCL SERVRUSSELL 2000 UTILITIES
RUSSELL 2000 OTHER
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
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F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Passive Strategies:Indexing Vehicles
– Index funds– Traditional tracking vehicle.
– Exchange Traded Funds (ETF) – Low operating cost, liquid and tax efficient.– Issues on brokerage cost and dividends.
– Futures and Synthetic Indexing– Mix of cash and long futures.– Lower transaction costs than ETF and index funds. – Uncertainty on rollover conditions and realized dividend.
– Swaps and Synthetic indexing– Pay Libor + Spread and receive the total return on an index.– No tracking error.– More cost-effective ETFs.– Liquidity and credit exposure issues.
12
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Passive Strategies:Transaction CostsETF Futures TRS ETF Futures TRS
Commissions 4 4Management Fees 15 6Spread 4 20 2 6Funding 9 9+20 17 17+15Stock Lending -9Dividends Tax 43 0 0 52 0 0Custody 4 4Net Cost 57 33 29 64 27 32Average Daily Deviation -0.14* -0.29** 0 -0.004* -0.005** 0Tracking Error 67 58 0 31 17 0
** Period Dec 02 to Jun 05 *Period Apr 00 to Jun 05** Period Dec 02 to Jun 05 *Period Jan 95 to Jun 05
Europe (STOXX 50) U.S. (S&P 500)
13
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Equity Risk Premium
On the long run, stocks outperform bonds.
On the short run, equity markets require risk control.
The equity risk premium.over 12-month and 36-month holding periods
-100%
-75%
-50%
-25%
0%
25%
50%
75%
100%
125%
Dec-93
Dec-94
Dec-95
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Equ
ity R
isk
Pre
miu
m
36M Holding Period
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F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Strategies: Option Based Portfolio Insurance (OBPI)
– Not a new idea: it was already invented in the late 1980’s.
– OBPI = buy a protective put option on the index.– May also be implemented through call options
– As for any insurance strategy, there is a premium to pay upfront.– an expensive protection implies a smaller amount to allocate to the index,
and therefore, a lower participation to the upside
15
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Strategies: Option Based Portfolio Insurance (OBPI)
Upside participation rate as a function of the capital protection required and the prevailing interest rate. The volatility level is assumed to be 25% for all cases, and
the maturity of the strategy is one year.
Capital protection 100% 95% 90% 85% 80%
2.0% 91.8% 93.9% 95.6% 97.0% 98.1% 3.0% 92.3% 94.2% 95.9% 97.2% 98.2% 4.0% 92.7% 94.5% 96.1% 97.4% 98.4% 5.0% 93.1% 94.9% 96.4% 97.6% 98.5%
Interest rate
6.0% 93.4% 95.2% 96.6% 97.8% 98.6%
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F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Strategies: Option Based Portfolio Insurance (OBPI)
– Out-of-the-money put options are usually far more expensive (in implied volatility terms) than at-the-money options.
– Fear of market crashes ?
– The set of available maturities for put options is limited and the longer term ones are often illiquid.
– Rolling out a sequence of short-maturity options results in a highly path-dependant strategy.
– Alternative– Dynamic strategy with a delta-based readjustment of the hedge.– Drawback: transaction costs, buy high & sell low path type.
17
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Strategies: Constant Proportion Portfolio Insurance (CPPI)
– Introduced by Perold, Black and Jones in the 1990s
– Simply stated: buy when the index rises in value and sell when it falls in value.
80
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100
105
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115
120
0%
20%
40%
60%
80%
100%
120%Exposure Index
CPPI Floor
Portfolio value Exposure level
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F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Strategies: Constant Proportion Portfolio Insurance (CPPI)
– In a flat oscillating market, however, the CPPI will do relatively poorly, as the investor buys on strength only to the see the market weaken
80
85
90
95
100
105
0%
20%
40%
60%
80%
100%
120%Exposure Index
CPPI Floor
Portfolio value Exposure level
19
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Strategies: Constant Proportion Portfolio Insurance (CPPI)
– In addition, the CPPI strategy is purely driven by the profit and losses of the portfolio, but has no consideration whatsoever of the risk conditions prevailing on the market.
20
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Strategies: Volatility Cap
– A dynamic allocation rule that aims at maintaining a constant target risk exposure (measured in terms of volatility) to equity markets.
– Systematically increasing the index exposure as the index volatility falls below the target and decreasing the index exposure when the index volatility rises above the target.
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150
0%
10%
20%
30%
40%
50%
60%
70%
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90%
100%
Exposure Index Vol Cap
Portfolio value Exposure level
21
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Strategies: Volatility Cap
– The VC strategy only attempts to provide downside protection by reducing the index exposure during periods of high volatility.
– No “guarantee” of a floor amount for the portfolio. – Completely ignores the P&L on the portfolio– Ignores any notion of risk budget.
22
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Indexation – Key Principles
– Determine the desired annual risk budget (10% p.a.).
– Derive a daily risk budget as a portion of this total risk budget.– Daily Risk Budget = Min (30% of the Total Risk Budget, 3% of
Portfolio Value)
– Establish the corresponding market exposure.– the portfolio’s daily 1% value at risk (at a confidence level of
99% in our case) is always equal to the daily risk budget.
– Adjust the exposure daily according to market volatility and P&L
– Issue a daily series of stop losses based on the available risk budget.
– Benchmark– The relevant index plus a one-year put option @ 90%.
23
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Indexation: Historical Comparison
Downside protectionMaximal loss: -10% (risk budget in the presented simulation).
Several cases of outperformance relative to the index.
-50%-40%-30%-20%-10%
0%10%20%30%40%50%60%
-60% -40% -20% 0% 20% 40% 60%
Index
Por
tfolio
Risk Controlled Indexation versus index: 1 year simulation, daily rolling, January 1990 to June 2004
24
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Risk Controlled Indexation
The RCI strategy. The numbers on the horizontal axis indicate the level of market volatility (basis of 100 at inception)
80
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115
100 143 83 68 39 41 44 43 44 43 45 44 43 43 129 136 136 135 124Volatility Level
0%
20%
40%
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100%
120%
Exposure Index RCI FloorPortfolio value Exposure level
25
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
VC in a Bear Market
65
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100
105
Nov-00 Dec-00 Jan-01 Mar-01 Apr-01 Jun-01 Jul-01 Aug-01 Oct-010%
20%
40%
60%
80%
100%
120%
Exposure IndexPortfolio Floor
VC Portfolio value Exposure level
26
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
CPPI – what would have happened
65
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100
105
Nov-00 Dec-00 Jan-01 Mar-01 Apr-01 Jun-01 Jul-01 Aug-01 Oct-010%
20%
40%
60%
80%
100%
120%
Exposure Index
Portfolio Floor
CPPI Portfolio value Exposure level
27
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
RCI - What would have happened
60
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105
Nov-00 Dec-00 Jan-01 Mar-01 Apr-01 Jun-01 Jul-01 Aug-01 Oct-010%
20%
40%
60%
80%
100%
120%
Exposure Index
Portfolio Floor
RCI Portfolio value Exposure level
28
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
RCI with an early market crash and a smooth recovery
Deep market fall early in the year brings the equity exposure close to its minimum level.
Market recovery is accompanied by a significant volatility which limits the exposition’s increase.
Discretionary decision could then be taken as whether to close the portfolio or inject some extra risk budget.
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Jul-9
8Aug
-98
Aug-9
8Sep
-98
Oct-98
Oct-98
Nov-98
Dec-9
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8Ja
n-99
Feb-9
9Mar-
99Mar-
99Apr-
99May
-99May
-99Ju
n-99
Jul-9
9
Por
tfolio
0%
20%
40%
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100%
120%
Exp
osur
e
Exposure IndexPortfolio Floor
Risk Controlled Indexation: early market crash simulation, 1 year period
29
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
CPPI – what would have happened
65
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105
115
125
135
Aug-97 Sep-97 Oct-97 Dec-97 Jan-98 Feb-98 Apr-98 May-98 Jul-980%
20%
40%
60%
80%
100%
120%Exposure Index
Portfolio Floor
CPPI Portfolio value Exposure level
30
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
VC – what would have happened
65
75
85
95
105
115
125
135
Aug-97 Sep-97 Oct-97 Dec-97 Jan-98 Feb-98 Apr-98 May-98 Jul-980%
20%
40%
60%
80%
100%
120%Exposure Index
Portfolio FloorVC Portfolio value Exposure level
31
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
CPPI in a crash and volatile recovery
65
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105
115
125
135
Jul-98 Sep-98 Oct-98 Dec-98 Jan-99 Feb-99 Apr-99 May-99 Jun-990%
20%
40%
60%
80%
100%
120%Exposure Index
Portfolio Floor
CPPI Portfolio value Exposure level
32
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
RCI – what would have happened
80
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105
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125
130
Jul-98 Sep-98 Oct-98 Dec-98 Jan-99 Feb-99 Apr-99 May-99 Jun-990%
20%
40%
60%
80%
100%
120%Exposure Index
Portfolio FloorRCI Portfolio value Exposure level
33
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
VC – what would have happened
65
75
85
95
105
115
125
135
Jul-98 Sep-98 Oct-98 Dec-98 Jan-99 Feb-99 Apr-99 May-99 Jun-990%
20%
40%
60%
80%
100%
120%Exposure Index
Portfolio Floor
VC Portfolio value Exposure level
34
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Capital Protection: Market Conditions & Summary Table
MARKET VOL. CAP CPPI RBPIBull Market, Low vol +++ +++ +++ +++Bull Market, High Vol +++ ++ ++ ++Bear Market, Low vol --- --- - --Bear Market, High Vol --- -- - -Flat Market, Low vol = = - =Flat Market, High Vol = = -- -
VOL. CAP CPPI RBPI
Downside Protection
Path Dependency
Trading Volume
Equity Exposure
Index Vol. Impact
No Yes Yes
YesYesYes
Depends on the index's
Vega
Depends on the index's Volatility
Limited
Determined by risk
budget and market risk
Determined by P&L to
date
Determined by current volatility
relative to target
Negative Impact
Negatively correlated to the exposure
Reduced exposure
35
F.S. Lhabitant
Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.
Conclusions
– An effective way to track an index while having some downside protection.
– The downside protection is based on risk, not just on P&L.
– Costs are extremely low.
– The strategy is highly scalable.
– We are happy…
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